From a personal savings and investment perspective, the restoration of long-term capital gains tax on equity income is a huge change.
From February 1 onwards, selling stocks or equity mutual funds that you have held for the long term will mean paying taxes on gains accrued since the market closing of January 31. If, in a year, you realise more than Rs 1 lakh of such gains, then 10.04% of that (including cess) has to be paid as tax.
So far, so good. You might resent this tax or you may console yourself that it’s at least a lot less than the 30% income tax slab
you are on. If that’s what you think, you may be getting ahead of yourself.
This tax could cost you a lot more than 10%. Even though the government will get 10% of your returns, you could actually lose 30 or 40% or even more of your returns, depending on how you invest. That’s bad news, but the good news lies in the phrase ‘depending on how you invest.’ You can limit these losses if you understand what’s going on and make tactical changes to your investing approach.
In December last year, when the first rumours of such a tax started floating, I had pointed out that over a long period like 10 or 15 years, an investor would lose a lot more money. The reason is that no equity investor is going to hold the exact same investments for such long periods. At some point, they would sell some of their holdings and buy something else. Given the structure of tax laws, capital gains would be taxed on each such switch, leading to less capital being available for compounding subsequently. The eventual impact would be quite large, but would differ for each investor depending on their buying and selling pattern.
Much worse, actually
However, Mr Jaitley has made this tax deeply unfair by not allowing inflation indexation. Inflation indexation is allowed for every other form of long-term capital gains in India—bonds, real estate, unlisted equity to name just a few. It is a cornerstone of fair taxation that the government cannot ask you to pay a tax on values that increase because of inflation. Why is this principle being ignored for this tax? There is no justifiable reason.
On an average, equity returns are rarely more than 3 to 4% above inflation. 10% of the full returns could easily be 20 to 30% of the real, inflation adjusted return. That’s right. This tax is likely to be 20 to 30% (sometimes more) of your returns on every transaction.
In fact, I’m being quite conservative in estimating the possible damage here. It is entirely possible that your real, inflation-adjusted returns could be negative and you will still have to pay this tax. Think of an investing period where your returns are, say, 8% and the inflation is 10%. For investments that have indexation, there would be no tax in this case. However, in this particular tax that Mr Jaitley has imposed, you would have to shell out despite having made an effective loss.
Do note that when such a tax used to be there before 2005, it had the indexation facility. So, the bottomline is that all other long-term capital gains taxes in our country have indexation except that on equity. Why this exception? There is no valid reason.
Three ways to soften blow
There are three ways of reducing this massive hidden impact of the capital gains tax.
The first is obvious: don’t buy and sell frequently. Choose all-weather stocks that will stand the test of time so that your holding period is long. The enhancement in your eventual returns will be huge.
The second is to invest in mutual funds instead of buying and selling equity directly. A mutual fund
investor can get the same returns but needs to buy and sell much less frequently. The trading is done inside the fund’s portfolio by the fund manager. However, as long as the investor holds on to the fund, there is no taxable event.
The third method is marginally useful and would take some understanding and work. Since Rs 1 lakh of gains every year are tax free, at the end of every year, you could sell investments that would generate that much returns and immediately buy them again. It would save Rs 10,000 a year, which would of course compound in the future.
ELSS Funds: There are other side effects of this tax too. For example, most investors think that tax-saving (ELSS) fund investments are completely tax-free, including the returns thus generated. This may not be true anymore, subject to the `1 lakh limit.
Distributors: Those fund investors who are entirely dependent on advice given by fund distributors inevitably have a high churn rate in their investments. In the new tax regime, this will be even more harmful to your eventual returns. All things considered, the introduction of even a 10% tax gives investors a lot to understand and adjust. We’ve been unused to this since 2005, but must re-adjust now.
The autor is CEO, VALUE RESEARCH